There is a lot of discussion among economists and market strategists about a “return to normal”. This primarily refers to a return to a neutral fiscal policy by the Federal Reserve from a period of unprecedented monetary stimulus resulting in artificially low interest rates. But, how do we define normal?
One way to estimate what normal interest rates should look like is to break economic growth into its components: labor force growth plus labor productivity. This provides a good estimate of real economic growth which is, after all, the gross production of our country’s total labor force. Historically, there has been a relationship between the economic growth rate and real interest rates. Interest rates historically reflect not only the rate of real economic growth, but also the expected inflation which today stands at about +2.0%. This analysis points to a US 10 Year bond that should be yielding somewhere around +4.0% if unshackled by the Fed.
Components of growth:
|Growth in the labor force||+0.5%|
|+ Productivity improvement||+1.5%|
|= Real Economic Growth||+2.0%|
|= Nominal Economic Growth||+4.0%|
Historical “Real” interest rates:
|+ “Normal” spread above inflation for US 10 Year||+2.0%|
|= Normalized Interest Rate on US 10 Year||+4.0%|
As one can see, “normal” looks very different from where we are today. Components of growth have been under pressure with labor force participation shrinking and productivity gains mysteriously weakening and has led to an expansion that falls short of the norm. Fortunately, real economic growth continues, albeit gradually, and inflation is tracking at an acceptable level. Our hope is that higher interest rates will follow stronger growth which will allow us to smoothly return to “normal.”